Friday, September 27, 2013

The Chinese saying ( 生, 老, 病, 死 = you are born, get old, get sick and die) that I quoted in my last post may be realistic, but it is not exactly an uplifting calling for life and it is no wonder that you look for an escape from its strictures. One option that almost every religion offers is the possibility of an afterlife, cleverly tied to how closely you follow that religon's edicts. For corporations approaching the end stages of their life cycle, this option is a non-starter, since there is no corporate heaven (unless you count starring in a Harvard case study or in a TV show as heavenly) or hell (though bankruptcy court comes awfully close). The other option is the possibility of a rebirth or reincarnation, in a different life, if you are Shirley Maclaine, or in the same life, if you manage to redefine yourself. After all, we are uplifted by stories of people who having experienced that rebirth; athletes who transition to successful business people (Magic Johnson) or actors who become presidents (Ronald Reagan). On this count, corporations have an advantage over individuals since they are legal entities that can reinvent themselves, while holding on to their corporate identities.

Looking back at history, there are companies that have beaten the odds of the business life cycle, fought off decline, and been reborn as successful ventures. Two examples that were noted in the comments section of the last post come to mind: IBM’s fall from glory in the 1980s and its subsequent rebirth as a vibrant corporation and Apple’s climb back from the dark days of 1997 to the top of the market capitalization table in 2012. As we think of these and other examples (and they are the favorites for obvious reasons for case study writers), it is worth noting that the very fact that we can name these companies suggests that they are the exceptions rather than the rule. Notwithstanding that sobering reality, it is still useful to put these success stories under the microscope, not only to get an understanding of what allowed these companies to succeed, but also to develop forward-looking criteria that we may be able to use in investing.

At the outset, I have to admit my trepidation about this exercise. First, I am not a corporate historian or strategist and I am sure that there is much that I am glossing over as I make my list of “rebirth” criteria. Second, I am always wary of drawing big lessons from anecdotal evidence, recognizing how easy it is to reach the wrong conclusions. Nevertheless, here are the common factors that I see in these success stories:

Acceptance that the old ways don’t work any more: To have a corporate rebirth, a company still has to get through the three step reaction to corporate aging that I noted in my last post and come to an acceptance that the old ways, successful though they might have been in the past, don’t work any more. That acceptance, as I noted, does not come easily or quickly and the longer and more hoary the history of the company, the longer it takes. Thus, while there are many younger investors whose experience with IBM has generally been positive, I remember the late 1980s when a series of CEOs at the company raised denial to an art form and almost pushed the company into irrelevance. Acceptance also requires more than lip service to change and has to be backed up by actions that indicate that the company is indeed willing to jettison big portions of its past.

A Change Agent: This may be a cliché but change has to start at the top. In fact, change at IBM really began when Lou Gerstner became CEO of the company in 1993. At Apple, the change agent was obviously Steve Jobs, a man who had been banished from Apple for his lack of focus a decade prior, but returned as CEO in 1997. It would be simplistic to say that the change agent always has to come from outside the company, because there have been companies where insiders who have spent a lifetime in the company have been willing to shake it up. (Bob Goiuzeta at Coca Cola and Jack Welch at GE were company men who still revolutionized their companies.) I think it is safe to say, though, that change agents are usually not shrinking violets and that they are ready to shake up the status quo.

A Plan for Change: Pointing out that the existing ways don’t work any more is important but it is futile unless accompanied by a new mission and focus. At IBM, Gerstner changed the mindset of the company (and its employees) early in his tenure, an incredible accomplishment given how deeply entrenched it was in the existing ways. Coming from RJR Nabisco, he brought both a customer-focus and a willingness to let go of IBM’s past mistakes (Anyone remember OS/2?) and this allowed him to create the modern IBM. Steve Jobs shocked Apple employees by entering into a détente with Microsoft, where in return for $150 million in cash and a promise by Microsoft that it would continue producing Office for the Mac, he essentially gave Microsoft a free legal pass to borrow from the Mac OS in updating Windows. He used the breathing room that this agreement gave him to redefine Apple as an entertainment rather than a computer company and the rest as they say is history.

Luck: Much as we would like to attribute success to great skill and failure to poor management, it remains true that the X factor in business success is luck. Gerstner was lucky that he made his changes at IBM in the 1990s, a decade of not only robust overall economic growth but especially so for technology companies. Steve Jobs was helped by the ineptitude of his competition, so blinded by their investment in the status quo (music companies to selling us music on CDs and cell phone companies thinking of cell phones as extensions of landline phones) that they either did not react or reacted too slowly to Apple's innovations.

I am sure that this is not a comprehensive list and that I have missed a few items but I want the list to be tractable because I intend to use it in my investment analysis. Companies that have been value traps can become great investments, if they can find a path to rebirth; an investor who bought IBM shares in 1993 or Apple shares in 1997 would have profited immensely from their reincarnations. So, as an investment exercise, you could prepare a list of the companies where stock prices have stagnated for long periods and check to see which of them have the ingredients in place for rebirth: an acceptance that the old ways don’t work (with tangible evidence in investment, financing and dividend decisions to back it up) and a change agent (new management), a new focus (with actions to back it up). The last factor, luck, is immune from assessment but you can consult your astrological signs or read the tea leaves, if it helps to make the right choices.

Putting this approach to use on Microsoft, Cisco and Merck, let's look at whether these companies have the ingredients for rebirth (and thus not be the value traps that I made them out to be). In the table below, I have listed the three ingredients (leaving out luck) and how each of the companies measures up on each ingredient.

Microsoft

Cisco

Merck

Acceptance

Not sure. The company still believes that it
can produce hardware (smart phones, tablets), using the same strategy that
worked for it on software (overload the product with features and overwhelm the opposition).

This is a company that had incredible success in the
1990s with its strategy of buying small technology companies and converting
them into commercial successes. That strategy failed over most of the last
decade. The company seems to be suggesting that it will scale back in the future, but while it has announced layoffs, its acquisition pace has not slackened.

Merck has been a mature pharmaceutical company for
two decades but its R&D policies suggest that it sees itself differently.
While there are noises coming from the company that are good (increased buyback, accountability in R&D), the company has been slow to adapt.

Change Agent

Steve Ballmer is leaving and a new CEO is coming in.
That is the good news. The bad news is
that this new CEO is being picked by the same board of directors at Microsoft
that seems convinced that nothing is wrong with the company.

The CEO who built this company up in the late 1990s was John Chambers. The CEO who made bad acquisitions during the last decade was also John Chambers. The CEO of the company that claims to have seen
the error of its ways is once again John Chambers. Unless he has multiple
personalities, I don't see how he can pull this off.

Who is Merck’s CEO? This may just be ignorance on my part but I had to
look it up: it is Ken Frazier, who has worked at Merck since 1992. I compliment the gentleman for keeping a low profile but change agents are not sell-effacing characters.

Focus/Plan

None that I can see (yet). The acquisition of Nokia
suggests that Microsoft is going to keep trying to go after the smartphone
business. Even if it
succeeds, that strikes me as more opportunistic and 'me too" than visionary.

The evidence suggests that Merck is slowly coming to
an acceptance that its historic model is running out of steam (stock buyback,
talk about cutting R&D) but there is little sense of what is going to
replace the existing model.

Rebirth Assessment

Change in CEO provides hope, at least for the moment.

Actions speak louder than words. If Cisco can go a
year without major acquisition & a new focus emerges, chances improve.

Looks like the best case scenario is that it is heading to the equivalent of
corporate “senior” living.

Of the three companies, I would argue that Microsoft offers the most in terms of possibilities simply because it is getting a new CEO, Cisco is talking the talk (of changing) but is not walking the walk and Merck seems to be stuck in a rut. You are welcome to disagree with me on my conclusions but even if you do, there is no reason why you cannot use the framework to make your own judgments.

Speaking of Apple, I am sure that there are many frustrated stockholders who are wondering whether the company is ready for another rebirth. Much as I like the company as an investment (and I value it at $600), I don't see the ingredients in place yet. While the company has capitulated on the financial front (agreeing to borrow money & buy back more stock) it still seems to be caught in the smartphone rat race with no end in sight. Tim Cook has shown his operating acumen but he does not strike me as a change agent and I am still unsure about his vision for the company. Maybe that will all change in the next few months, but I am not holding my breath!

Tuesday, September 24, 2013

The last few days have been filled with reminders for me of both the destructive and the redemptive powers of life. The weekend started with a family outing to a Yankee game. As a fan, it was wrenching to see Mariano Rivera and Andy Petite, two players who I have watched for almost two decades, pitch for the final time in Yankee stadium, but it was redeemed at least partially by a young Yankee pitcher, Ivan Nova, pitching a complete game on Saturday. Yesterday was my birthday, a joyous day marred only by the realization that putting as many candles on the cake as my age merited would likely set off fire alarms. Before I could feel sorry for myself, though, my eighteen-year old daughter, a freshman in college, called, exhilarated about getting a hundred on her first college exam. Towards the end of the day, the story that Blackberry had an offer to be taken private by Fairfax Financial for $4.7 billion crossed the newswires, an occasion for mourning not just by longtime Blackberry users but for anyone who appreciates life changing technologies, but that story was accompanied by one from Apple, announcing that the company had sold nine million iPhones over the weekend.

A Life Cycle view of Business

A Chinese saying, that we are all born, grow old, get sick and the die (生, 老, 病, 死), which provides an unvarnished assessment of the cycle of human life, can be extended to businesses as well. Businesses too are born, grow with vigor, mature, decline and die; some, of course, die early and never see growth and some live longer, more productive lives. If the fundamentals of corporate finance can be boiled down to a investment choices of a business (the investment decision), how those choices are financed (the financing decision) and how and when cash is returned to the owners of businesses (the dividend decision), those decisions can be framed in terms of the business life cycle:

The business life cycle also shapes how we approach valuation, with the principles not changing, but the focus shifting at each stage of the cycle. When valuing young, growth companies, the drivers of value are almost invariably in the investment choices that the company makes and the effects of those choices on both growth and profitability. Thus, with Tesla and Facebook, it is the revenue growth and target operating margins that determine value and not how much debt they have in their capital structure or how much they pay in dividends. When valuing mature companies, the focus in valuation changes to valuing existing assets (and their earning power) and to the effects on value of better financing and dividend choices. Thus, for Apple, as much of the discussion of value is focused on whether the company will gain from its use of debt and buying back stock as it is on the future growth of the company. When valuing declining companies, the focus is on winding down portions of existing businesses, while repaying debt due and returning as much cash as possible, in a timely fashion, to stockholders. In my December 2011 post on Blackberry, I estimated a value of about $ 9 billion for the company, on the assumption that the best course for the firm was to narrow its focus to a niche product (I called it the Blackberry Boring, a phone for security-conscious corporates that would prevent games, apps or other distractions from getting in the way of employees checking their email) and liquidate itself over time (five years) in an orderly fashion. I followed up by looking at Blackberry (RIM) and Nokia as potential contrarian plays in June 2012, but luckily, I went with Nokia as my pick. That option play paid off partially because Nokia recovered from its lows but the big payoff came, ironically, when Microsoft bought them early this month.

Reactions to Decline: Anger, Denial and Acceptance

If aging is part of being human, it is just as human to fight aging and businesses seem to follow the same script. Rather than accept maturation and decline as inevitable parts of the business life cycle, businesses seem to go through their version of the stages of grief, starting with anger (at markets), denial (about being mature or in decline) and final acceptance.

Stage 1: Anger

When growth companies transition to becoming mature companies, the market responds by lowering the multiples that they are willing to pay for earnings and some investors demand that the company behave like a mature company, borrowing more and returning more cash to its stockholders (in dividends and buybacks). In many of these companies, managers respond first by accusing markets (and by extension, their own investors) of being short term and ignorant of the facts. While that characterization may fit some (or even many) investors, it still remains true that markets are often more perceptive than managers are.

Stage 2: Denial
Managers, angry at investors for treating their companies as mature or declining, make it their mission to prove the world wrong by going for more growth, and in the process, often do further damage to themselves and their investors. The impetus to fight maturation and decline is fed by four factors:

The emotional connection: In the midst of the Second World War, when it was clear that Britain could no longer hold on to its far flung colonies, Winston Churchill was quoted as saying that "I have not become the King's First Minister in order to preside over the liquidation of the British Empire." Many managers at iconic companies that have fallen into decline tend to go along with this sentiment, especially if (like Churchill) they were involved in building up the companies in the first place. That explains why a Michael Dell would leave a comfortable retirement in 2007 to return to his namesake company as CEO, in a futile attempt to turn the company around.

Fountain of youth ecosystem: Just as there is a lucrative ecosystem that makes money of the desire to stay young (cosmetic surgery, magic supplements, hair transplants etc.), there is an even more lucrative ecosystem of bankers, consultants and turnaround experts who promise mature and declining companies that they will lead them back to everlasting growth. They play to management egos and offer them hope, while eating through billions of dollars of stockholder money, with little to show for it.

Analyst Growth Obsession: Many equity research analysts are obsessed with earnings growth, judging companies on how much they grow rather than on how much value that growth adds. Thus, a declining company that invests badly to grow at a low rate is viewed as better than a declining company that shrinks, while paying out large dividends. Not surprisingly, managers feel the need to feed this obsession for growth.

The PR problem: If your business is declining and your growth prospects don't look good, the right thing for you to do as a top management is to accept that reality, convey it to your employees and start shrinking the business. However, that is not painless and people will lose jobs, employees will see their paychecks shrink and customers will lose their favorite products. If you are in the public eye, you (as the CEO) will be labeled a Scrooge or worse. It is no wonder, therefore, that companies that are serious about facing up to decline prefer to do so as private businesses rather than as public companies.

While denial is understandable, it is also costly to investors. As I have noted in a prior post, growth can be value destructive, if it is expensive. In fact, to illustrate the effects of “value destroying” growth, I have taken a base case of a mature company, with no growth prospects and $100 million in after-tax earnings that pays out its entire earnings as cash flows. If you attach a cost of capital of 10% for this company, its value is $ 1 billion (=$100 million/.10). Now assume that the managers of this company decide to push for growth, though that growth requires them to invest immense amounts of capital (in acquisitions, R&D and new projects) with a return on capital of 5%. In the figure below, I have the value of the company at different growth rates.

You can consider the difference between $1 billion and the estimated value of a company at any given growth rate to be the cost of denial to investors in the company. Thus, at a 5% expected growth rate, the value of the company is $792.47 million and the cost of denial by managers (and for stockholders) is $207.53 million. (You can play with the spreadsheet by clicking here).

This analysis should open investors eyes to a clear and an ever-present danger when investing in mature and declining companies that look cheap (on a value basis or even based on a PE or PBV ratio). Those companies are cheap, only if their managers don’t try too hard. In fact, the more activity there is on the part of management to "fix" the growth problem, the less cheap the companies become. To me, this is the key to understanding “value traps”, companies that look cheap on every metric but stay cheap forever. To offer you three examples, consider Cisco, Microsoft and Merck’s stock prices over the last decade:

These are companies that I have seen tagged as cheap companies repeatedly over the last ten years, but none of them would have delivered much in terms of returns. These three companies had management teams that have tried hard to return them to growth status, spending billions of dollars in that venture: Merck in R&D, Cisco on acquisitions and Microsoft on “new” products. I know that I have the benefit of hindsight here, but I would wager that investors in these companies would have been better served, if they had lowered their sights on growth and focused on delivering the most earnings from existing investments and returning the cash back to stockholders.

I decided to take a shot at valuing Microsoft by breaking it down into the value of assets in place (Microsoft Office and Windows, for the most part) and expected value of growth. In the fiscal year ended June 30, 2013, Microsoft reported $26,764 million in pre-tax operating income on revenues of $77,849 million; revenues increased by 5.60% over the previous year but operating income was down 4.26%. Using the company's effective tax rate of 19.2% for the year and attaching a cost of capital of 8% to the company (in the 60th percentile of US companies), you can value Microsoft assuming no growth in the future:

Value of assets in place (with no growth, no reinvestment) = $26,764 (1-.192)/ .08 = $270,316 million

Adding their cash balance of $ $77,022 million on June 30 to this value and subtracting out the debt outstanding of $15,600 million yields an estimated value of equity of $331,738 million, about $61,198 million higher than the market cap of $270,540 million. Put briefly, assuming no growth in earnings, Microsoft is worth about 22% more than its market capitalization. You can take give the spreadsheet a try, if you are so inclined. (I know that I may be overstating the value of assets in place by assuming that Office and Windows will generate earnings in perpetuity, but using a fifteen-year annuity yields a value close to the market price.)

It is no wonder then that Microsoft keeps looking cheap using all the standard metrics (PE, EV/EBITDA etc,) but there may be a core problem that we are ignoring. For most of the last twenty years, Microsoft has spent billions on new technologies and products and has little to show for it. While it is difficult to isolate the return on capital on just these new investments, it is quite clear that it has been less than the cost of capital. I think I am being generous to Microsoft in assuming that its' new ventures have earned an average return on capital of 6%, but with that assumption, it is quite clear that if Microsoft continues to keep trying for growth, it will be value destructive, as shown in the figure below:

The intrinsic value of Microsoft drops with every increment in growth and at a growth rate of 7% for the next decade, the intrinsic value converges on the actual market price. This may explain the horrific reaction that the market had to Microsoft's announcement that it would acquire Nokia for $7.2 billion, and Microsoft's market capitalization dropped by more than $15 billion. It may not have been the acquisition per se that triggered the drop off but the signal that it sent to investors that Microsoft with its new CEO (from Nokia) would keep trying to grow. The best news, if you buy int this analysis and you are a Microsoft investor, would be an announcement by the firm that they are disbanding their R&D department, stopping all new product development and appointing Larry the Liquidator as their new CEO.

Stage 3: Acceptance

Ultimately, no matter how hard you fight aging, reality sets in. For individuals fighting middle age, the moment of awakening may be a torn muscle from trying to run a fast break on a basketball court, but for businesses, it may take a longer time. In some cases, it may require pressure from activist investors and in some, a new top management who has no emotional connection to the company's history. In some, though, it will be forced upon the business by external factors, difficulty making a debt payment or an inability to retain employees.

What form will acceptance take? If the business is mature, it will start behaving like a mature firm, tilting its capital structure towards more debt and increasing cash returned to investors. For many followers of Apple, that capitulation seemed to happen in their March earnings report, where the company ratcheted down its forecasted growth, announced its first debt issue and increased its stock buybacks.

If the business is in decline, it may be the acceptance that the future will not only be less rosy than the past but also a plan for gradual or partial liquidation. That, to me, seems to be the message in the proposed Blackberry deal. Fairfax Financial is the largest stockholder in Blackberry and its chief executive, Prem Watsa, has been labeled the “Canadian Buffett”. His plans seem to be to focus on Blackberry’s business services and to throw in the towel on the smartphone and tablet businesses. Will he succeed? I hope so but I think he has his work cut out for him. The company has done significant damage to its orderly liquidation prospects in the two years since my last valuation and it may be too late to turn this ship around.

It's really not too bad

On a personal note, I am older today than I was yesterday but given the alternative, I am okay with that. I really don't want to be eighteen, twenty three or twenty five again, not because those were not great years, but so was my most recent year. I could tell you that I know more today than I did three decades ago, but that is really not true, but I do know more about what I don't know today than I did three decades ago (if that makes any sense). Keeping with the theme of this post, I know that my Tesla/Facebook days are way in my past (I am not sure that I had them), that my Google days are in my rearview mirror, that I am probably in the Apple days of my existence (which is really not too bad) and that I will one day be in my Blackberry/Microsoft phase of life. I can only pray that when that phase arrives, I will have the grace to do an orderly winding down of my activities and not keep reaching back in time for the glory of bygone days. In the meantime, I will get my revenge on time by using it as productively as I can.

Wednesday, September 18, 2013

I have a Facebook account, but I almost never post. I also have a Linkedin account, but it is a not premium, largely because I am not that interested in finding out who is looking at my profile or endorsing me (often for skills I don't have). I do have a Twitter account and while I don’t post very often, I just like the ease with which it lets me bug thousands of people. All of this is of course a lead in to the story that I am sure will dominate the financial news for the next few weeks: Twitter is planning its initial public offering and everyone has an opinion on what it will be priced at.

While I will try to value Twitter when the time is right, I am going to use this post to price Twitter, not value it, for three reasons. First, Twitter’s financial statements are still inaccessible, a consequence of the JOBS Act (passed last year) that allows “emerging companies” (with revenues < $1 billion) to use a confidential process for filing with the SEC. Unlike some who are worked up about the resulting lack of transparency, I am not in high dudgeon about this non-disclosure. The company will have to provide a full prospectus a few weeks before the shares are priced (and offered) and there will be plenty of time for me to do my due diligence. Second, the lead investment bank (Goldman Sachs) will be pricing the company for the offering, not valuing it, and I want to use this post to take a look at that process. Third, if you choose to play this IPO game, to win, you have to be able to play the pricing game well, not get the value right.

The tools/inputs of Pricing
To value a business, you start with raw data from a company’s financial statements, draw on measures of risk and operating efficiency for the business in which it operates, make estimates for the future and use a valuation model (with my preference being for a discounted cash flow (DCF) model). To price a company, you draw on a different set of inputs and tools, with the following standing out:

1. Current price: This may sound circular but the key input into the pricing process is the current price of the asset. After all, in pricing, you are accepting the market’s judgment of price as the only number that ultimately matters. With publicly traded companies, this dependence on the price takes the form of charts and technical indicators, which can then be mined for clues about future price movements. Looking at a still private company like Twitter, this approach may seem like a non-starter, since it has no public market, but there have been transactions in the past that provide clues about its price. Some of these transactions involve venture capital investments, where you can extrapolate from the investment and the share of the company received by the venture capitalist to the overall price of the company is. Others involve private sales by one investor to another, where again the transaction price provides clues as to the the overall price. The following graph, drawn mostly from a Wall Street Journal news story on the company, imputes prices for Twitter based upon trades over the last few years on the company’s equity.

Note that the imputed price of equity in Twitter was $100 million in 2008 and that the price has surged over the last three years, rising from $ 1 billion in late 2009 to $ 9 billion early this year and $10.5 billion a week ago. Much of the surge occurred in the latter half of 2011, after Linkedin went public to a rapturous market response in May of that year.

Is it okay to extrapolate from isolated transactions to overall price? Yes and no. There is information in the transactions but the price estimate can be skewed by three factors. The first is that the transactions may not be at arms length, resulting in a price that has less to do with what the transactors think the business is worth to them and more to do with side objectives (control, taxes). The second is that even in an arms length transaction, the value that you impute may not be reflective of the fair price for a publicly traded company but may reflect instead the pricing of a private, illiquid business (which is lower). The third is unless the most recent transactions occurred very recently, the price you get is stale and will have to get updated to reflect both market and sector developments. With Twitter, none of these concerns rise to a serious level: the venture capital transactions are motivated by profit, the company has been priced as company that will go public for the last two or three years and there are at least two recent transactions from this year. The first reflects the sale of 15% of the company to Blackrock, with an imputed price of $9 billion for the company. That transaction was in January 2013 and both the market and social media companies have risen in price, since then; the S&P 500 is up 20% since January and Facebook & Linkedin, the two social media companies that are viewed as closest to Twitter, have gone up even more over the same time period (Linkedin has doubled and Facebook has gone up about 67%). Applying even the market change (20%) to Twitter would yield a value of $10.8 billion, and applying the social media appreciation number would increase that value to $16-$18 billion. In September 2013, just a few days ago, Twitter bought MoPub, a mobile advertising exchange, and issued stock to cover the transaction cost. Imputing the value of Twitter from the share issue leads to an imputed price for Twitter estimate of at least $10.5 billion. Thus, just based on these two private transactions, the price of Twitter should be at least $10.5 billion and perhaps a bit more.

2. Relative value: The other commonly used tool in pricing is relative value, where you set the price for an asset by looking at the prices at which comparable companies are traded at in the market. The process of applying this approach to price a company like Twitter can be complicated by two factors.

a. Scaling variable: Since the units into which you divide value (number of shares) is by its nature arbitrary, you need to scale the price to a common variable. That, of course, is the role of a multiple, whether it be PE, Price to Book or EV/Sales. In the context of young, growth companies, where earnings and cash flows are often negative and book value is meaningless, analysts either focus on revenues, and/or scale the price to some measure of operating success (users, subscribers etc). With Twitter, a revenue multiple can be utilized to estimate value, even if its financial statements report a net loss or EBITDA for the year. The table below provides the multiples estimated in September 2013 for Facebook and Linkedin in the first two rows, as well as a broader sample of firms that loosely derive their revenues from online services (though some like Netflix are subscription based and some like Pandora get a mix of advertising and subscription based revenue):

All the normal caveats apply. The accounting numbers reflect trailing 12 month estimates, but in companies like these, these numbers will change dramatically from period to periods, as will the number of users and employees. The number of users disguises wide differences among them, with heavy, mild and completely idle users aggregated together and sometimes double or triple counted. The value per users will be skewed by differences in business models, with companies like Netflix that have subscription based revenues registering much higher values.

Even with the very limited public numbers that you have for Twitter, you can start estimating prices, using these multiples. For instance, if the news stories that peg Twitter's most recent twelve-month revenues at $583 million are right, you could apply the revenue multiple of 17.45, that its two closest competitors ($FB & $LNKD) trade at, to arrive at a value of $10.17 billion, fairly close to the most recent transaction price. (Twitter's cash balance would have to be added to this number to get to a market capitalization.)

Twitter's estimated enterprise value = $583 * 17.45 = $10.17 billion

Before you get too excited about this convergence, recognize that applying the median EV/Sales ratio of 8.67 for the social media medley to Twitter's revenues yields a value of $5.05 billion, making the $10 billion plus numbers being bandied about look awfully high.

Twitter's estimated enterprise value = $583 * 8.67 = $5.05 billion

Just to round out the estimates, you could always apply the multiple of $130.32/user that investors are paying collectively for Linkedin and Facebook to Twitter's 240 million users (I have seen wildly varying estimates of this number with some estimates ranging up to 500 million) yields a price of close to $25 billion.

Twitter's estimated market capitalization = $130.32 * 240 = $24.4 billion
I have estimated a range of prices for Twitter based upon the different combinations (multiple, choice of comparable firms, averaging approach):

Which one of these is the right price? That depends on what your priors are about Twitter and perhaps what you are trying to convince me to do. If you believe that it is a great company that will also be a great investment, you will go with the combinations that yield the higher number. If you are convinced that this is the next bubble that will burst, you will use the lowest values to justify selling short or warning people away from the company. It is no wonder that equity salespeople latch on to this approach. All you have to do is find the right mix of multiple and comparable firms and you can back up any sales pitch (that the company is cheap, expensive or correctly priced) you want to make about any company. If you are on the other side of this sales pitch, it has be caveat emptor.

b. Current versus Forward Numbers: To the extent that your multiples are skewed or meaningless because current values for earnings, book value and capital expenditures are small and meaningless (in terms of forecasting future values), you can try to forecast the values for each of these items and apply a multiple (based usually on what other publicly traded companies are trading for today) to get the estimated value in the future. Getting from that future value to value today can be dicey, as I illustrated in my last post on Tesla, as risk, time value and dilution all eat into the terminal value. It is also worth noting that while this may be easy to do for a young growth company in a sector where most of the competitors are mature, it will be difficult to do with Twitter, where the lead competitors, Facebook and Linkedin, are also in high growth and will change over time.

The Drivers of Price
Just as the tools and drivers of pricing are different from those of value, the drivers of price vary from the drivers of value. Thus, while value is determined by cash flow, growth potential and risk, price is determined by a different set of variables:

Momentum/Mood: Much as intrinsic value investors tend to disdain momentum, it remains true that momentum is one of the most powerful forces driving returns with stocks. Studies indicate that over shorter time periods, momentum based investing often delivers much better results than fundamental based investing. For some stocks, especially those in "hot' sectors, momentum is the key driver of prices, drowning out news about the fundamentals.

Incremental news: Once you accept the pricing proposition that the market price is what it is, the key to winning at the pricing game becomes forecasting changes in price rather than assessing whether the current price is right. As a consequence, your focus on news stories will become incremental and each news story will be assessed in terms of how it will change the price, rather than how it will affect overall value.

Liquidity: If you invest based on long term value, you can afford to put liquidity on the back burner for two reasons. First, the cost of illiquidity (higher transactions costs) can be spread over your long holding period, reducing its impact on your returns. Second, since you are not investing on momentum and not as dependent on timely trades for your profits, you can afford to wait to buy or sell, rather than have to do so in the middle of market chaos. If you are trying to make money on pricing, liquidity or the lack of it can not only make the difference between making and losing money, but in extreme cases, can lead to disaster (especially if you have a pricing strategy accompanied with high high leverage).

The Dangers of Pricing
The pricing game can generate large profits in short periods but it comes with a warning label. It is not for the faint hearted, since it is accompanied by risk. The market can make mistakes in the aggregate:

Markets can be wrong in the aggregate: I know that active investors view those who believe that markets are efficient (I don’t…) as eggheads or worse. It is worth noting, though, that many of these same active investors are “pricers”, who pick stocks based upon multiples and comparable firms. In effect, they are assuming that markets are right in the aggregate, but make mistakes on individual companies, which would make them semi-believers in market efficiency. If markets are wrong in the aggregate, you can be right in your relative assessment (that a stock looks cheap relative to its competitors) and still lose large amounts (if they are all over priced).

Mood shifts (inflection points): To the extent that price is driven by momentum and mood, shifts in that mood can very quickly turn profits to losses. The key to winning at the game therefore becomes detecting inflection points (where positive momentum turns to negative momentum) and altering your investment strategy. This is the promise of charting and technical analysis, where price and volume patterns yield clues about future momentum shifts. Even the best indicators, though, often fail at this task. It is also worth noting that momentum is fragile and based partly on illusions. If bankers show contempt for the process and its players (as I think Facebook and its bankers did at the time of their IPO), the momentum may very well shift.

Taxes and transactions costs: As a general proposition, playing the pricing game requires you to have a shorter time horizon and to trade without regard to tax consequences. Thus, if you buy a momentum stock and profit over the ten months that you hold it but you detect a shift in momentum, you will sell the stock and take your profits, even though you face a much tax bill as a US investor (if you had held for a year, you could have qualified for capital gains).

Implied assumptions: Many analysts and investors who use multiples justify that usage by arguing that intrinsic valuation require too many assumptions and that pricing/relative valuation does not. I would argue that any multiple has embedded in the same assumptions but that they are more implicit than explicit. Take Twitter, where the key assumptions are about how much revenues will have to grow and what the target operating margins will be on these revenues. In the table below, I have estimated the multiple of revenues that you would be willing to pay for any company, given how your expect revenues to change over the next ten years and the operating margin in year 10. For simplicity, I have left the risk (cost of capital) and quality of growth (reinvestment) unchanged. (My hypothetical company had a cost of capital of 12% to start, moving towards an 8% cost of capital in perpetuity and a return on capital in 12% after year 10.)

This table can be used in two ways. If you believe, for instance, that Twitter's revenues will increase ten-fold (from $538 million to $5.38 billion) over the next decade and that its target margin will approach 30%, you would be willing to pay 12.71 times Twitter's current revenues for the company (12.71*583 = $7,409 million). Conversely, if you are intend to pay 20 times current revenues (about $11.6 billion) for Twitter, you would need revenues to increase fifteen-fold over the next decade and margins to converge to about 32% in year 10. (I will update this table when Twitter's financial statements come out.)

A Cynical View of the Twitter IPO Pricing Game

If you decide to play the pricing game, you will have lots of company. In fact, I would argue that much of what passes for valuation in investing is pricing. In an IPO, in particular, how a company is priced for a public offering and what happens in the after market, at least in the months following the offering has more to do with pricing than value.

So, here is my take on what will happen. Goldman Sachs will start with the latest transaction value for Twitter, approximately $10.5 billion, and adjust it up for the improvement in both the overall market and in social media companies (especially Facebook) since the start of the year. They will then create a sales pitch for that value, using the pricing of other social media companies (Facebook and Linkedin, in particular) to argue that Twitter is a bargain at their estimated price. (My guess is that they will focus on the number of users and how Twitter looks like a bargain on that basis.) That sales pitch will be tried out on institutional investors for effect, with the salespersons’ ears especially attuned to either too much enthusiasm from these investors (a sign that the price was set too low) or to little (a signal that it is et too high). The institutional investors, not having a clue about the fair value of Twitter, will talk to each other and ratchet up or down their own enthusiasm based upon what they sense in their compatriots. The investment bank, having tweaked the price based on investor reactions will then do a discounted cash flow valuation, reverse engineered to deliver that price as the final value. (A good test of their valuation skills will be in how well they hide this reverse engineering to make it look like the valuation led to the pricing rather than the other way around). Finally, having learned from the Facebook fiasco that it is better to under price rather than over, they will knock off about 15% off their estimated price/value to set the offering price. At the risk of being hopelessly wrong in hindsight, I would be very surprised if I saw Twitter priced lower than $10 billion or higher than $15 billion, unless there is a major market disturbance. (As a point estimate, I would guess that it will be priced around $12 billion. In fact, let's start a shared Google spreadsheet of our price guesses. They are based on nothing more than rumor and minimal information, but why let that stop us?)

Am I being cynical? Perhaps, but I think we would all be better served if the process was stripped off its veneer of value. If we honestly faced up to the reality that this is an exercise in pricing and not valuation, the bankers can dispense with their quasi DCF models that they have no belief in, focus on pricing the stock and recognize that they will be judged on their pricing and deal making skills, not their valuation expertise. The issuing companies will recognize that their role in the process is to act as facilitators in the marketing, packaging the company like a shiny present and providing incremental news that pushes the price in the right direction. The investors who decide to play the IPO game or invest in the after market will not waste their time and resources estimating value, since their success or failure will come from how well they gauge momentum shifts and time their exits. I will value Twitter, when the financials are released and the time is right, but my advice to you is that you ignore my valuation, if you are playing the IPO game. The market for Twitter will little note nor long be concerned with my or anyone else’s assessment of value.